I posted some thoughts about the financial crisis last week. Here’s some more about how technology helped create the derivatives markets in all its complexity and obscurity.

It’s a well-known fact that Wall Street exists to help make businesses run well, helping them raise cash and grow profitably. Financial transactions, it is understood, serve economic and social purposes. But as Roger Lowenstein points out in The End of Wall Street (2010) those purposes were undermined and perverted in the years running up to the 2007-2009 financial crisis. Before the 1990s Wall Street’s profits averaged about 1.2% of GDP. By 2005, that percentage had risen to 3.3% of GDP.“The proper end of Wall Street is to oil the nation’s business,” Lowenstein writes. That end “became, in the bubble era, a goal in itself, a machine wired to inhuman perfection.”

That Wall Street machine included the automated securitization programs, which, using computer technology, created “structured” products that contained pools of securities. The Wall Street machine also included the mathematical models for forecasting the performance of those complex products under certain conditions over time.

What computers ended up enabling was a series of derivative financial instruments, each type of which was higher in risk and had less real economic purpose as time went on. At each step along the way the banks added more complexity, which in turn created more abstraction and obscurity. Eventually the machine fed upon itself, building structured products that were detached from economic meaning. They offered investors pure side bets on other financial instruments. It is a picture of a machine gone mad in a market that had ceased to understand its own raison d’être.

Complex digital technology also defined who could participate in the derivatives market. These “innovative” structured products were only available to the large investment banks and commercial banks who could afford the technology and infrastructure needed to define and manage such complexities. In fact, none of this would have possible without sophisticated computers and the quantitative scientists who used them.

Here’s how the series of derivatives developed over a period of years, including what they are, their economic purpose, the pitfalls, and how they evolved (or devolved) over time.

Mortgage-backed securities

What

These were bonds that contained pools of individual home mortgages. Wall Street banks would buy mostly prime mortgages (at least at the start) from smaller banks and other lending institutions. They would then group them into different levels (called “tranches”) based on the amount of risk involved and the return. The ratings agencies would certify the risks and assign ratings such as triple-A or triple-B.

Economic purpose

As Wall Street purchased the mortgages, they gave much-needed cash to the smaller institutions, who in turn lent the money to other home buyers, making mortgages more plentiful. Secondly, by pooling the debt into bonds, Wall Street was able to distribute to investors the risks of those initially fixed-rate mortgages.

Pitfalls

The smaller institutions, who sold whole mortgages to Wall Street, effectively risked nothing in lending money to home buyers, paving the way for mortgages that were far riskier because of floating rates, insufficient credit checks on buyers, and other murky practices. Also, Wall Street banks paid the rating agencies for each ratings project so they could shop around for the rating they wanted.

How things devolved

More mortgages were subprime, often with low teaser interest rates that disappeared in two years. Interest-only mortgages became popular, along with other practices that practically insured high rates of default. In addition, banks hid the details of the mortgages from the ratings agencies, making the rating process less than perfect. Moreover, banks also knew the criteria the ratings agencies used in their models for rating those bonds so they could “game” the system.

Credit default swaps (CDSs)

What

First created in the early nineties, these were a form of insurance for investors in mortgage-backed securities. An investor would pay the insurance company (initially AIG) a premium. In turn, the insurance company would agree to pay the bond holder should the mortgages default.

Economic purpose

Investors in mortgage bonds could hedge against the risk of default on the mortgages in a bond.

Pitfalls

Anyone could buy a credit default swap. You didn’t have to own a mortgage bond. In this way the product was easily disconnected from its original economic purpose. (It’s as if you could buy flood insurance on a house on a flood plain without owning the house.) This made the side bets (selling “short”) possible. This also meant that derivative traders could profitably mint and sell unlimited quantities of these products to whoever wanted to “bet” on mortgage defaults.

Secondly, the insurers, initially AIG, misunderstood the risks involved. For some years, they had been “insuring” corporate bonds, which have an extremely low rate of default. They just assumed that mortgage-backed bonds were similar in their risks. They weren’t. As a result, they sold insurance at far too low a price. Thus they might collect $10M in premiums and guarantee $20B in bonds. This made credit default swaps a cheap gamble for those who wanted to bet against the mortgage bonds.

How things devolved

As the subprime mortgage industry grew, there were many more investors willing to speculate on its demise. The market for credit default swaps burgeoned in the late 90s and onward.

Collateralized debt obligation (CDOs)

What

These were bonds created by packaging up a hundred or so mortgage bonds (or, to make it yet more complicated, portions of those bonds). Since each mortgage bond might contain 1000 mortgages, a CDO might contain bonds representing hundreds of thousands of mortgages.

Economic purpose

Banks could offer new derivatives with high returns and low risk, and they had spiffy models that seemed to demonstrate this over time. But eventually a CDO became, as Michael Lewis describes it in The Big Short, just a laundering scheme for lower middle class home buyers. It enabled the subprime market to flourish.

Pitfalls

CDOs were so complicated and so abstract that it was just about impossible to understand the risks involved. And all investors had to go on were the models and the ratings. Also, it required $50B worth of original mortgages to create a $1B CDO, making them harder to come by.

How things devolved

Beginning in 2004, the mix in the mortgage-backed bonds began to shift heavily into subprime loans until about 95% of the bonds were subprime (originally only about 2% of mortgage-backed bonds were subprime). Usually the “portions” of the bonds that were packaged into a CDO were the lowest (triple-B) rated mortgages. The models that re-rated the riskiest bonds as triple-A could do so, according to the financial wizards on Wall Street, because the likelihood that many of them would default at the same time was extremely low. Even sophisticated Wall Street investors did not understand how the rules of the game were changing. The ratings agencies didn’t have models for CDOs, so the banks who packaged the derivatives would send their own models to the ratings agency when asking for an official rating. Hence both the models and the ratings were wrong.

A synthetic CDO simply provided a way for investors to bet on the mortgage and housing industry but, in fact, a CDO served no real economic purpose.

Pitfalls

The ratings agencies didn’t have a clue as to the value of these complex and obscure derivatives. Neither did investors.

How it devolved

In the process of evaluating a synthetic CDO based on the computer models built by the banks, the rating agencies rerated to triple-A roughly 80% of the credit default swaps on triple-B-rated bonds. Of course the remaining 20%, which were rated triple-B, were harder to sell. So the banks would repackage a bunch of the credit default swaps on triple-Bs and reprocess them. Each time 80% of those bonds were rerated triple-A.

The subprime mortgage market was really only a small percentage of the whole mortgage industry. But because there were no real economic limitations on the number of credit default swaps, the losses in the financial sector through both credit default swaps and synthetic CDOs grew much bigger than the subprime market itself creating a tower of liabililties